12.6 Changes in exchange rates
We have already discussed the effect of exchange rate changes in the context of consolidation of accounting records. We resume that discussion here in the context of the control process. A subsidiary may fail to achieve the profit goals set out in its budget, not because of any performance problems but merely because of a decline in its local currency against the MNE's home currency. Similarly, a fictitious improvement in the subsidiary's performance can occur because of an improvement in the local currency against the home currency.
The Lessard-Lorange model offers a range of methods for dealing with the currency exchange rate problem. This model is a 3 x 3 matrix in which the nine boxes are derived from combinations of three exchange rates. They are:
|
the spot exchange rate at the time the budget is set. |
|
the spot exchange rate forecast for the end of the budget period; that is, the forward rate. |
|
the spot exchange rate at the end of the budget period when budget and performance are being compared. |
Refer now to Table 12.1 (Figure 19.3 in your textbook) and follow the accompanying description which is given under the heading 'The main points'.
Table 12.1 Possible combinations of exchange rates in the control process (Source: Hill 2005, p. 660)
|
|
Initial (I) |
Projected (P) |
Ending (E) |
|
Initial (I) |
(II) |
(IP) |
(IE) |
Rate used for translating budget |
Projected (P) |
(PI) |
(PP) |
(PE) |
|
Ending (E) |
(EI) |
(EP) |
(EE) |
The main points from Table 12.1 are:
- Boxes PI, EI, IP and EP are illogical. For example, in box EI, it makes no sense to use the ending rate to translate the budget and the initial rate to translate actual performance. Check the other three boxes for yourself.
- In box IE, the ending exchange rate to evaluate performance may be quite different from the initial exchange rate used to translate the budget.
- In box PE, the distortion is less than in IE because the projected exchange rate for the budget takes into account future exchange rate movements.
- Boxes II, PP and EE use the same exchange rate for both budget and performance. A change in the exchange rate during the year does not distort the control process.
- Box PP is recommended by Lessard and Lorange because the projected rate will typically be the forward exchange rate as determined by the foreign exchange market (check the definition of forward rate in Chapter 6).
- Lessard and Lorange also suggest the use of a company generated internal forward rate. This rate may differ from the forward rate quoted by the foreign exchange market if the firm wishes to bias its business in favour of or against the particular foreign currency.
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